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Carry Trade and Liquidity Risk: Evidence from Forward and Cross-Currency Swap Markets

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Abstract

This study empirically examines the effect of foreign exchange (FX) market liquidity risk and volatility on the excess returns of currency carry trades. In contrast to the existent literature, we construct an alternative proxy of liquidity risk - violations of no arbitrage bounds in the forward and currency swap markets. We also use volatility smile data to capture FX-market specific volatility. The sample data cover periods both before and after the Global Financial Crisis (GFC). Both proxies are significant in explaining the abnormal returns of carry trades, particularly after the GFC. Our findings provide substantial evidence that uncovered interest parity (UIP) puzzle can be resolved after controlling for liquidity risk and market volatility.

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File URL: http://www.qfrc.uts.edu.au/research/research_papers/rp310.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 310.

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Length: 35
Date of creation: 01 Aug 2012
Date of revision:
Handle: RePEc:uts:rpaper:310

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Keywords: uncovered interest rate parity; carry trade; liquidity risk; no-arbitrage bound; volatility;

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  1. Ingo Fender & Patrick McGuire, 2010. "European banks' US dollar funding pressures," BIS Quarterly Review, Bank for International Settlements, June.
  2. Angelo Ranaldo & Paul Söderlind, 2007. "Safe Haven Currencies," Working Papers 2007-17, Swiss National Bank.
  3. Burnside, A Craig & Eichenbaum, Martin & Kleshchelski, Isaac & Rebelo, Sérgio, 2008. "Do Peso Problems Explain the Returns to the Carry Trade?," CEPR Discussion Papers 6873, C.E.P.R. Discussion Papers.
  4. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
  5. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking," BIS Quarterly Review, Bank for International Settlements, March.
  6. Brunnermeier, Markus K & Pedersen, Lasse Heje, 2007. "Market Liquidity and Funding Liquidity," CEPR Discussion Papers 6179, C.E.P.R. Discussion Papers.
  7. Mitchell, Mark & Pedersen, Lasse Heje & Pulvino, Todd, 2007. "Slow Moving Capital," CEPR Discussion Papers 6117, C.E.P.R. Discussion Papers.
  8. Charlotte Christiansen & Angelo Ranaldo & Paul Söderllind, 2009. "The Time-Varying Systematic Risk of Carry Trade Strategies," CREATES Research Papers 2009-15, School of Economics and Management, University of Aarhus.
  9. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
  10. Adrien Verdelhan & Hanno Lustig, 2005. "The Cross-Section Of Foreign Currency Risk Premia And Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2005-019, Boston University - Department of Economics.
  11. Naohiko Baba & Frank Packer, 2009. "From turmoil to crisis: dislocations in the FX swap market before and after the failure of Lehman Brothers," BIS Working Papers 285, Bank for International Settlements.
  12. Markus K. Brunnermeier & Stefan Nagel & Lasse H. Pedersen, 2009. "Carry Trades and Currency Crashes," NBER Chapters, in: NBER Macroeconomics Annual 2008, Volume 23, pages 313-347 National Bureau of Economic Research, Inc.
  13. Craig Burnside, 2007. "The Forward Premium is Still a Puzzle," NBER Working Papers 13129, National Bureau of Economic Research, Inc.
  14. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
  15. Naohiko Baba & Frank Packer & Teppei Nagano, 2008. "The spillover of money market turbulence to FX swap and cross-currency swap markets," BIS Quarterly Review, Bank for International Settlements, March.
  16. Baba, Naohiko & Packer, Frank, 2009. "From turmoil to crisis: Dislocations in the FX swap market before and after the failure of Lehman Brothers," Journal of International Money and Finance, Elsevier, vol. 28(8), pages 1350-1374, December.
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